MARKETS TO DATE. SO FAR (AND NOT VERY FAR) SO GOOD

MARKETS TO DATE
SO FAR (AND NOT VERY FAR) SO GOOD

Two weeks into 2006 and the broad market indices have made some progress.
The S&P 500 has moved from 1248 to nearly 1288 as of 1.13.06, a move of about 3%. The NASDAQ has jumped to 2,317(1.13.06) from 2205, up 5%. And the DJIA is up from 10,718 to 10,959 (1.13.06), an increase of 2%. The DJIA even closed above 11,000 on 1.9, 1.10 and 1.11.

The S&P 500 equal-weighted index, represented by the ETF RSP, is up 3%, in line with the capitalization weighted S&P 500 index.

MARKET MAXIMS:
AS GOES THE FIRST WEEK OF JANUARY, SO GOES JANUARY
AS GOES JANUARY, SO GOES THE YEAR

These maxims are correct more often than they are incorrect. So 2006 may be a good year, it may not be. Can we be more nebulous and evasive?

The Author’s investment methodology is trend-following, not predictive. It is a concentrated investment strategy, nor a diversified one. It is Buy and Sell, not Buy and Hold(while the price plummets). It is a relative strength, momentum based methodology. It is straightforward and simple to explain. And it is not extremely difficult to execute. It is an engine that gets more finely-tuned over time, not a crystal ball that gets better reception the more it is polished.

A REMINDER OF THE AUTHOR’S METHODOLOGY (Reprinted, in main, from the 8.2005 Desert of the Real Newsletter)

Studies show that 70 to 80% of a stock’s movement can be attributed to the movement of the overall market and the movement in the particular stock’s sector. Yet most analysts concentrate their efforts on analyzing a stock’s fundamental indicia. And most portfolio strategists just conjure up newer quantitatively derived strategies for portfolio diversification.[1] So most of what you read or hear about a stock from the analysts only influences 20-30% of its movement. How would you like a doctor that could only cure 20% of your ailments or a fire department that would only respond to 30% of fire alarms?

AN OVERVIEW OF HOW IT WORKS

1. When the stock market is moving forward, you are fully invested in stocks. When the market is reversing course, move to wealth preservation strategies. I am sure some readers are thinking ‘Yeah, right smart guy. How can you tell when the market is going to move up?’ The simple answer is you cannot predict when it will go up or down. But you can employ technical indicators that are trend tracking and trend following. You stay invested until these technical indicators reverse to negative.
2. Within all markets, some sectors will outperform others. Find the best sectors and find the best performing stocks in those sectors.
3. When you find the best stocks in those sectors find the best price points to buy, sell, and plot stop loss points. On this last point, proper implementation of stop loss orders is key to a good strategy. It sounds counterintuitive, but knowing when to cut losses is as important (if not more important) as knowing what to buy.

Here is why:

A. If you are buying good stocks in a moving market, you are almost sure to get gains that beat, or at least equal, market-equivalent gains. If you do it well, you will substantially exceed the relevant indices.
B. Despite your best efforts, some of your picks will lose money. That is inevitable. Just keep your losses very small and put your money elsewhere. Being a stock trader is like managing a major league baseball club. The season stretches from April to October. You are bound to lose some games, but consistently win more than you lose and you will keep your job and your club will make the playoffs.
C. Put in stop losses and be mechanical about them. The author usually sets stop loss orders at 7% below the purchase price, or a point on the chart where short-term price support will break down. No exceptions. Also, when you have good gains in a stock, raise the stop-loss price to keep your profits.

The author did not create all of this methodology. It is in part his methodology, in part the methodology used by Dorsey, Wright and Associates.[2] Let’s talk a little about the Author’s investments over the past six months with an eye toward providing the readers some insights.

In September and October, the Author moved his portfolio to a defensive configuration based upon the market indicators he follows. These are medium-term and short-term relative strength and momentum indicators. They were all negative at that point. This portfolio included lots of cash, inverse funds, or mutual funds that operate inversely to the S&P 500 and the NASDAQ. So when these indices dropped, the funds went up. And gold, an investment the Author has never held. But the chart and indicators looked good.

But late in October, something happened. The indicators reversed and we switched from defense to offense. The Author sold the defensive investments. To get quick equity market exposure, the Author bought RSP, the equal-weighted S&P index ETF. After some time for research, the Author bought emerging markets, Korean, and Latin American ETFs, and other investments in fast moving sectors such as oil services and Internet. These investments will be held until they lose relative strength, market indicators move to negative, or chart patterns reverse.

When the market turns negative again, the Author will put investments in place that will work more effectively in a down market. Like the defensive portfolio described above.

WHAT’S NEXT? WHO KNOWS?

We do know that this market will reverse, but we do not know when. We will have indications, as certain shorter-term indicators stall and reverse. At this point we will become more cautious. When the indicators all reverse, we put the defense and the wealth-preservation strategies in place.

We know that all assets will revert to their mean pricing. But that does not mean we will hold on to them as our account balances revert with them. Buy when things are moving up-sell when things are moving down. Simple? No. But mechanical indicators do most of the work for us. We just need to watch them and listen to them. And most importantly, do what they tell us.

ONE EAR ON THE GROUND, ONE EYE ON THE TACHOMETER IN THE DESERT OF THE REAL!


IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.


[1] Try saying that real fast with a medium binder clip on your tongue. And then try putting all of the binders back in their box so the office supply martinet will not discover that you used office supplies in an unauthorized manner.
[2] www.doreseywright.com. There are probably other investment services that employ a similar methodology, but the author likes DWA. He vets all of his potential investments through the Dorsey Wright System. An attractive feature of DWA methodology is that it also works in reverse. In a falling market, the methodology can help you find the weakest stocks in the weakest sectors. It will then help you find crucial short sale and short cover prices. NOTE: This should not be interpreted as a recommendation of DWA’s services. Investors should carefully examine all investment strategies to determine which will fit their individual need.